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An Idea Incubator Tries To Grow Cash

March 11, 2007

Germany's Fraunhofer Society, a sprawling collection of 56 scientific research institutes, has played a big role in developing technologies ranging from medical scanners to solar energy to car air bags. But its biggest invention may be blasting the latest U2 or Red Hot Chili Peppers tunes into your ears right now.

The MP3 standard for digital music led to Napster (NAPS), iPods, and a massive disruption of the recording industry. It was largely the work of a half-dozen researchers at Fraunhofer in the 1980s and early 1990s, as well as private groups such as Bell Labs in the U.S. The impact of that effort came into stark relief on Feb. 22, when a federal jury in San Diego slapped Microsoft Corp. (MSFT) with a $1.5 billion judgment for using MP3-related patents claimed by Alcatel-Lucent (ALU), which now owns Bell Labs' intellectual property.

The court case is just the latest unexpected outcome of a project begun in the 1980s. While still in graduate school, Karlheinz Brandenburg began working on transmitting music via digital telephone lines. He later joined Fraunhofer and, after years of toil with colleagues at the society, helped MP3 beat competing technologies to become the global standard for digital music on the Internet.

For Germans, the invention of MP3 is a source of pride—and chagrin. MP3 patents generate tens of millions of dollars in licensing fees for the nonprofit Fraunhofer. But the really big money went to non-German companies that make MP3 players, such as Microsoft, Sony (SNE), and, of course, Apple (AAPL), which uses MP3 technology in its iPods and iTunes software (see BusinessWeek.com, 2/26/07, "Apple's International iTunes Controversy"). "We tried to push [the technology] to German companies, but they were often too slow," says Brandenburg, now 52 and director of the Fraunhofer Institute for Digital Media Technology in the eastern German city of Ilmenau.

THE NEW MUSE

Along with the World Wide Web (the Internet browsing interface invented in Geneva but appropriated by Silicon Valley), MP3 has come to symbolize Europe's knack for missing tech opportunities. At Fraunhofer, at least, the soul-searching had an effect. The society, founded by the German government in 1949 to conduct research for industry and defense, began to focus on profiting from its inventions. For example, Fraunhofer began giving seed money to startups using its technology. One is Iosono, a spinoff 25% owned by Fraunhofer, which makes equipment to produce super-realistic sound in theaters.

Perhaps most important, MP3 has been an inspiration to Fraunhofer's 12,500 researchers. Many of them work in relatively unglamorous fields such as power-plant technology or auto electronics, with most of the credit for their work going to companies such as Siemens (SI) and DaimlerChrysler (DCX) that provide financing. "Whenever you have a real champion, that increases motivation for the whole organization," says Ulrich Buller, a member of the Fraunhofer executive board.

Fraunhofer could use a boost. The outfit gets only 20% of its budget from the German government and needs to earn the rest from contract research. MP3 royalties, meanwhile, fell 45% last year, to $78 million, as the initial surge of companies buying licenses has subsided. Still, the nonprofit is forging ahead with work that builds on its MP3 expertise. In January, Fraunhofer unveiled the latest version of MP3 Surround, which creates the illusion of surround-sound with standard stereo speakers. Not bad for something that started out as a grad school project. "I did not believe," says Brandenburg, "this would affect hundreds of millions of people and change the whole music industry."